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Risks Associated with Director Loans to Insolvent Companies, Including Bankruptcy

While a company that’s in financial trouble (and possibly facing liquidation) can affect a lot of people, it can be particularly hazardous for its directors.

And one such hazard comes from director loan accounts.

What is a director loan account?

During the life of the company, there may be situations where:

  • the director draws money from the company, or is paid amounts that aren’t wages
  • the company pays expenses on behalf of a director
  • the company genuinely lends money to the director.

Funds paid to (or on behalf of) the director in these situations can be accounted for as a wage, with PAYG tax being withheld from the wage and remitted to the Australian Taxation Office. But if they’re not, then a director loan account is recorded in the company’s financial statements, usually as an asset, although it can be recorded as a negative liability.

Once a director loan is recorded, it becomes recoverable as a debt due to the company.

If there isn’t a loan agreement in place, the loan is usually recoverable at call (i.e. immediately repayable on demand).

What’s the problem?

For a company that’s solvent without any risk of being placed in liquidation, there is no problem. Well, unless the directors are also shareholders, in which case the loan will be subject to the provisions of Division 7A of the Income Tax Assessment Act.

But if the company is in financial trouble, or has been placed into liquidation, then the loan amount can be recovered by the Liquidator. They may take action to recover the loan and start legal proceedings against the directors. If a Liquidator obtains a judgment against a director for a director loan account, the Liquidator can use that judgment to bankrupt the director.

That’s the problem.

What’s the solution?

Prevention is always better than cure, and so care should always be taken when accounting for payments made to (or on behalf of) a director, especially if the company is having financial difficulties.

But if a director loan has already been recorded, here are four ways to deal with it:

  1. Repay the loan to the company.
  2. Offset the loan against any loans owed to the director by the company.
  3. If circumstances allow, declare a dividend, and then use it to clear or reduce the loan account balance rather than paying it out (subject to Section 254T and possibly Part 5.7B of the Corporations Act).
  4. Take a reasonable salary from the company that is offset against the loan account rather than paid

One thing that should never be done is to “remove” the loan from the company’s financial statements. Unless it has been repaid, a move like this could result in a breach of director’s duties, or having various recovery claims pursued in the company’s subsequent liquidation.

The next step

As you can see, a director loan account can be a problem for a company that’s in financial trouble and there can be serious consequences for handling it the wrong way.

So if you’re a director of a company in financial trouble, and you’ve got one or more director loans on your books, get in touch with us today so we can talk about your options and the best way to move forward.

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